Sustainable finance Quiz 1

Six capitals of Integrated Reporting (IIRC 2013)

Financial, manufactured, intellectual, human, social and relationship, and natural capital

Financial capital

Pool of funds available to a firm for producing goods or services, obtained through financing (debt, equity, grants) or generated by operations and investments (retained earnings)

Manufactured capital

Physical objects the firm uses to produce goods or services, such as buildings and equipment

Intellectual capital

Intellectual property (patents, copyrights, software) plus organizational capital (tacit knowledge, systems, procedures, protocols). Often just called intangibles

Human capital

People's competencies, capabilities and experience, and their motivation to innovate. Includes job satisfaction and health and safety conditions

Social and relationship capital

Institutions and relationships within and between communities, stakeholder groups and networks, and the ability to share information to improve individual and collective well-being

Natural capital

All renewable and non-renewable environmental resources and ecosystem services (e.g. water purification, climate stabilization) that support the firm's past, present or future prosperity

In the six capitals diagram, which capital surrounds all the others and why?

Natural capital, because every other capital ultimately depends on the environment

What does higher leverage mean for a firm?

More funding from lenders, so more fixed interest payments and higher financial risk

What does a high retained earnings ratio tell you?

More of the firm's funding was generated internally rather than raised externally

What does the SA (Size-Age) index measure?

Financial constraints, using only firm size and age. Small, young firms find it hardest to raise funds so they are the most constrained (Hadlock and Pierce 2010)

What does high capital intensity mean?

The business relies heavily on physical assets (e.g. airlines, utilities, manufacturers)

What does an asset age ratio close to 1 mean?

Assets are old and largely used up, so they will need replacing soon

When is a firm's physical asset base growing?

When capex is larger than depreciation

Why does knowledge capital need to be rebuilt with a formula?

Accounting rules expense R&D, so the knowledge asset is invisible on the balance sheet. The perpetual inventory method estimates it by accumulating past R&D and depreciating it

What is organization capital and how is it estimated?

Processes, brand, customer relationships, training and culture. Estimated by treating a portion of SG&A spending as an investment that depreciates over time

Intangible share of capital

Share of the firm's total capital (intangible plus physical) that is intangible

Human capital measure - employee satisfaction

Proxied by the Best Companies list or Glassdoor ratings. Firms with more satisfied employees earned higher long-run stock returns (Edmans 2011)

Injury rate (human capital)

Recordable injuries per 100 full-time workers, which lets firms of any size be compared

Employee turnover (human capital)

Share of employees who leave in a year. High turnover means lost skills and hiring costs

CSR score (social capital)

Strengths minus concerns from MSCI ESG (KLD) data. A higher score signals more trust built with stakeholders

What is ACSI and what did research find?

American Customer Satisfaction Index. Firms with more satisfied customers had higher stock returns with lower risk (Fornell et al. 2006)

Customer concentration (HHI) - how to read it

Near 1 means the firm depends on one customer, near 0 means many small customers

Why does customer concentration matter for social capital?

It shows how dependent the firm is on a few relationships

Lins, Servaes and Tamayo (2017) finding

During the 2008-09 crisis, high-CSR firms had stock returns 4-7 percentage points higher. Social capital and trust paid off when trust was scarce

Carbon intensity

Scope 1 + 2 (+ 3) emissions per million dollars of revenue, in tonnes of CO2-equivalent

CO2-equivalent

Converts other greenhouse gases (e.g. methane) into their CO2 warming effect

Scope 1 emissions

Direct emissions from sources the firm owns (factories, vehicles)

Scope 2 emissions

Indirect emissions from purchased electricity, heat or steam

Scope 3 emissions

All other indirect emissions in the value chain (suppliers, product use). Full value chain emissions from products the firm buys, makes or sells

Scope 4 (not in the GHG Protocol)

Reduction in clients' Scope 3 emissions achieved through the company's smart solutions

Toxic releases measure and the finding

Pounds released across plants (EPA Toxics Release Inventory). More polluting firms earn higher stock returns as compensation for regulatory risk (the pollution premium)

When is water intensity most important?

In water-stressed regions and water-heavy sectors

Which standards guide financial capital reporting?

IFRS S1 (ISSB) which shows connectivity between sustainability and financial statements, and the International Integrated Reporting Framework

What do companies do to report financial capital well?

Explain how sustainability risks affect cash flows, cost of capital and access to funding. Report green bonds and sustainability-linked loans

Sustainability-linked loan

A loan whose interest rate depends on hitting ESG targets

How do you monetise financial capital?

It is already in money, so book equity, market cap or retained earnings can be reported directly

Standards for manufactured capital

IAS 16 (PP&E - review useful lives yearly), IAS 36 (impairment), IFRS S2 (physical climate risks to assets)

Stranded assets

Assets that lose value or close early because of the transition (e.g. fossil-fuel plants that may close early)

Tobin's q - what it means

Market value divided by replacement cost. A q above 1 means the market values the firm above its physical assets, pointing to intangible capital or growth

Alternative way to monetise manufactured capital

Revalue PP&E at current replacement cost instead of historical cost (allowed under the IAS 16 revaluation model)

Standards for intellectual capital

IAS 38 Intangible Assets (research is expensed, development capitalised only if strict criteria are met) and the WICI Intangibles Reporting Framework

Relief-from-royalty method

Values IP by the royalties the firm saves by owning the patent or brand instead of licensing it. Discount the after-tax royalty savings to present value

Kogan et al. (2017) patent valuation

Estimates patent value from the stock price reaction when the patent is granted

Standards for human capital reporting

ISO 30414, US SEC Regulation S-K Item 101(c) (2020), and SASB industry labour metrics

Turnover cost method

Leavers times the cost of replacing each one (recruiting, onboarding and training to full productivity)

Market premium approach to human capital

Best Companies earned about 3.5% a year above risk-adjusted benchmarks (Edmans 2011)

Lev-Schwartz model

Values human capital as the present value of employees' future earnings (Lev and Schwartz 1971)

Lev-Schwartz extensions

Weights each year by the probability the employee is still alive, and later versions (e.g. Flamholtz) also allow for the chance the employee leaves

Limitations of Lev-Schwartz

Assumes pay equals value to the firm, basic version ignores turnover, and the firm does not own its employees so they are not an asset under IFRS

Which company disclosed a Lev-Schwartz workforce valuation?

Infosys, in annual reports during the 1990s-2000s

Standards for social and relationship capital

GRI Standards (e.g. GRI 413 local communities, GRI 414 supplier social assessment) and the Social and Human Capital Protocol (Capitals Coalition 2019)

What do companies do to manage social capital?

Run stakeholder materiality assessments, audit suppliers on labour and human rights, and measure community programmes with SROI studies

SROI (social return on investment)

Present value of monetised social outcomes divided by the investment. E.g. 3.2 : 1 means every dollar invested creates 3.2 dollars of social value

Standards for natural capital

GHG Protocol, IFRS S2 climate disclosures, TNFD (2023) nature-related disclosures, Natural Capital Protocol (2016)

Internal carbon price

A price companies put on emissions when making investment decisions

Environmental profit and loss account

Puma valued its 2010 environmental impacts at about 145 million euros, and Kering now publishes one yearly

Social cost of carbon

Dollar value of the damage from one extra tonne of CO2. US EPA (2023) estimate is 190 dollars per tonne

How do you use the social cost of carbon to monetise natural capital?

Multiply emissions by the social cost of carbon to get annual damage cost, then compare it with EBITDA to see how much profit is offset

Impact-weighted accounts (Serafeim et al. 2019)

Harvard approach that reports environmental cost as a percentage of EBITDA

Three routes to convert an ESG index into dollars

A) Market valuation (hedonic) B) Cost-based C) Shadow pricing

Route A - market valuation (hedonic)

Regress Tobin's q on the index with controls, then convert the coefficient into dollar value. These are associations, not causal effects

Route B - cost-based valuation

What it would cost to rebuild or restore the capital (hiring and training costs, remediation, replacing equipment)

Route C - shadow pricing

Physical quantity times a unit value (tonnes of CO2e times carbon price, injuries times cost per injury, outcomes times SROI proxies)

Why must monetised values always state their method?

They are estimates, so you must disclose the method, unit prices and discount rate used

Biggest bottleneck to the sustainable finance transition (Week 3)

Behavioral and societal, not technical. Can we change how we consume and produce?

Dasgupta and Ehrlich (2013) calculation

If 6.2 billion people in poor and middle-income countries matched the consumption of 1.3 billion people in high-income countries, we would need two more earths

Population projections cited

Currently close to 8 billion, expected 9.7 billion by 2050 and 11.2 billion by 2100 (World Bank 2017)

Which SDG is linked to the shift from linear to circular consumption?

SDG 12 Responsible consumption and production

Today's unsustainable consumption and production patterns

Competitive consumption, overconsumption, linear production (take-make-use-waste), and lock-in by incumbents' lobbying

Competitive consumption

Keeping up with the Joneses, where people consume to match or beat others

Linear production

Take, make, use, waste. Resources are used once and then discarded

Circular production

Make, use, reuse, recycle. Renewable energy is used and materials are reused and recycled

Collaborative consumption

Sharing or peer-to-peer economy where participants share access to products or services instead of owning them (Airbnb, Uber, bike and car sharing)

Nudging

Using conformity to make the sustainable choice the norm. People follow conformity more than competition

Investor bias - extrapolation

Markets price assets as if the recent past continues, so no transition is assumed

Phase transitions

Revolutionary changes to business models that do happen even though markets price for continuity

Remedy for investor extrapolation bias

Broaden and lengthen the horizon. Use scenario analysis to test portfolios against several possible futures, and move from market index to fundamental analysis of investee companies

Players in sustainability

Government, civil society, investors, corporates and households

Government's role and horizon

Country or global sphere, horizon up to 4 years (electoral cycle). Tools are taxation and regulation. Threats include free-riding, policy differences, corruption and shortfall of efforts

Civil society's role

Public voice of NGOs (Oxfam, Amnesty, Greenpeace, WWF). Sets the agenda and stimulates citizenship. Threats are single-issue focus, fragmentation and dependence on government goodwill

Investors' role in sustainability

Use investment and lending strategy and engagement (PRI, FCLT Global, GIIN, GABV, Equator Principles). Threats include monthly benchmarking, long investment chains and marking-to-market

Corporates' role in sustainability

Key players for transformation through procurement and production processes. Threats include quarterly reporting, shareholder-value thinking, lobbying for the status quo and relocating production to less strict countries

Households' role in sustainability

Ultimate beneficiaries who steer through buying decisions, the sharing economy and voting. Threats include poverty, lack of trust in government, free-riding and human aversion to change

PRI

Principles for Responsible Investment. Leading global advocate for responsible investment

What does the PRI do?

Researches how ESG factors affect investment outcomes and supports its network of investor signatories in building ESG into investment and ownership decisions

Why is the PRI described as independent?

Not for profit, not tied to any government, and backed by the UN without being part of it

PRI Principle 1

Incorporate ESG issues into investment analysis and decision-making

PRI Principle 2

Be active owners and incorporate ESG into ownership policies and practices (voting, engagement, shareholder resolutions)

PRI Principle 3

Seek appropriate disclosure on ESG issues by the entities invested in

PRI Principle 4

Promote acceptance and implementation of the Principles within the investment industry

PRI Principle 5

Work together to enhance effectiveness in implementing the Principles

PRI Principle 6

Each report on activities and progress towards implementing the Principles

Three levers financial firms can pull to steer business toward sustainability

1) Use their ownership (governance, stewardship, engagement) 2) Broaden the lens beyond financial returns to social and environmental 3) Lengthen the horizon from short term to long term

Finance-as-usual

Creates shareholder value, ranks financial value only, maximises F, short-term horizon

Sustainable Finance 1.0

Refined shareholder value. F is much more important than S and E, maximise F subject to S and E, short term

Sustainable Finance 2.0

Stakeholder value (triple bottom line). Integrated value I = F + S + E, optimise I, medium term

Sustainable Finance 3.0

Common good value. S and E rank above F, optimise S and E subject to F, long term

What do F, S, E and I stand for?

F = financial value, S = social impact, E = environmental impact, I = integrated value

Corporate governance

Managing conflicts of interest between the owners of a firm and the people who run it